How Reliable is EPS For Deciding the Stock Performance?

You would have heard this term EPS or earning per share many times from many fundamental analyst But you may still wonder what is this EPS.  It is a ratio that denotes the net profit or loss credited to the share holders for every share held. It is a widely used financial ratio that plays a vital role in valuation of the shares of the company.

The term “earnings” used here denotes the part of the company’s income that rightfully belongs to the shareholders. It is obtained by subtracting preferential dividends and the taxes levied on them from the net profit and loss after taking into account special income and expenses incurred during the financial year.

Also the number of shares issued in a year can change if a buyback or bonus or rights issue is offered by the company during the financial year under consideration. If that happens, to compute EPS, the weighted average of the issued shares is used. The weight of each share is considered in proportion for the financial period in which it has been issued.

Calculation of EPS

EPS can be calculated as

EPS = Profit After Tax / Total number of equity shares issued by the company in the financial year

Unreliability of EPS as measure of stock performance:

Despite being an important ratio, EPS can be quite an unreliable indicator of stock performance. It does not take into account the opportunity cost of capital and is influenced by short-term activities.

E.g. A company has 10,000 issued shares and the shareholders’ earnings is Rs. 100,000. The EPS here is Rs. 10 (100,000/10,000). Now the company issues bonus shares in the ratio of 1:1. It means now the total shares issued goes to 20,000. The new EPS now becomes Rs. 5. So despite there being no change in the earnings of the company, the EPS has decreased. This makes EPS an unreliable factor in deciding the share performance.

Also if the company takes a loan to buyback shares, the shareholders have to bear responsibility of this debt. As the equity base is reduced, the earnings are affected. Also there is no connection between the EPS and the capital invested. E.g. two companies with equal EPS may not have the same level on invested capital. If the invested capital is higher, the returns earned are more.

how reliable is EPS

So to to conclude EPS is definitely a reliable factor that reflects the companies performance, but if there is a case of bonus issue or buy back it could become unreliable and in such cases you should look at other factors also.

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